Friday, October 3, 2008

CDOs, CDSs, and the Panic

Republicans have been making an effort to lay this entire mess at the feet of the Democrats. This is entirely consistent with their ongoing efforts to avoid responsibility for anything bad that might have happened while they were in charge of the government.

Republicans controlled all three branches of government for most of the decade, including the critical years that saw a peak in the issuance of sub-prime mortgages. (If the Evil Democrats (TM) were so effective that they were able to run the government during those years, maybe they really should be elected, if only to replace the staggering ineffectiveness of the Republican majorities.)

CDOs peaked in 2006.

According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totaled US$ 157 billion in 2004, US$ 272 billion in 2005, US$ 552 billion in 2006 and US$ 503 billion in 2007.

Not that it's relevant, since this is something that would be regulated by the administration in power, not the Congress.

The Republican argument hinges on the idea that Pelosi and Reid were able to affect the rates of mortgage writing immediately upon taking power (even before passing any major relevant legislation), but that the Republican administration was helpless to stop them.

If the Republicans are such a bunch of feebs, why would I vote for them?

The truth is that both parties bear a portion of the blame for the crisis.

While the focus of the mainstream media has been on CDOs, the role of CDSs has been underreported.

Credit default swaps sit at the center of this whole mess. There are several times the level of outstanding debt contained in what amount to little more than casino-style bets. While these have existed in the past, they really came into vogue during the last decade.

Here's a reading assignment for the masochistically inclined:

Ok, I'll take mercy on you. The bottom line is that these are a way for investors to get insurance via an investment vehicle. Why don't they call it insurance? Because then it would fall under a number of state-level regulations, since insurance is regulated by the states. Among other things, insurers are required to prove that they have enough cash reserves to pay any reasonably expected number of claims.

So all the investment banks "share" risk by selling each other insurance. Now what happens if you have a systematic failure, where everyone needs to file a claim on their insurance?

Lousy shame that nobody managed to ask that question when they were designing their risk models...

So why didn't the regulators realize that insurance was being sold in a relatively unregulated environment? I'll leave that one as an exercise for the reader...

Here's a much better explainer:

Some key sections that should really tick you off:
As with reclamation of strip mines, the insurance companies will file for bankruptcy. Government, via a $700 billion emergency rescue plan, will step up to the plate. The costs will be paid by taxpayers who have seen only losses and no gains. Pursuant to a rescue plan that prohibits any and all forms of congressional or judicial oversight or opportunity to object.

Except for reports, to be filed twice yearly. Something akin to the fox being required to periodically report how many chickens he stole from the hen house, without being required to return any of the stolen chickens. And who will keep this count? The fox.

The inevitable bankruptcy of A.I.G? What other option exists for a company with a market value of $12 billion and liabilities of about $450 billion on credit default swaps written to hedge funds, many of which are headquartered offshore and thus pay no taxes in the United States. For this, the government is paying $85 billion in taxpayer's money. In return, the government, meaning the taxpayers, will be entitled to receive 80 percent of the company's stock. Stock that is all but assured to be totally worthless.

For insurance company executives, financial risks of corporate bankruptcy are all but non-existent. Lehman Brothers is a prime example. On September 15, Lehman filed bankruptcy - the biggest in America's history. Hours before, the New York headquarters was scrambling for cash. Other banks were refusing to provide loans to Lehman. Banks with loans outstanding were demanding immediate repayment. Counter parties to Lehman's credit default swaps were selling out at ten cents on the dollar.

Lehman's response: Hours before the bankruptcy filing, Lehman transferred $2.5 billion from the London office to the American holding company. This money had "accrued as part of group profits from the first nine months of the year" and will be used to pay employee bonuses. As a result, the London office had no funds with which to make the payroll.
Paulson, who steadfastly refuses to consider taking a hard look at A.I.G. and other financial firms. How could these companies, managed by the so-called "best and brightest" guys in the room, have committed such a long and horrendous series of "poor judgments"?

By accident, or sheer incompetence?

Hard to believe, given that everyone in the room knew millions of explosive mortgages were being written to families without sufficient income, or in some cases no documentation of any income at all, based on fraudulent appraisals and supported by fraudulent AAA ratings.

Given the size and blatant nature of the disaster, accident and incompetence excuses simply don't fly. Something more was involved. That something is the number and size of vultures who bet on and stand to gain from the disaster, and how much they stand to gain. Too many people owning fire insurance on my neighbor's valuable house.

Even though I agree with almost all of the above, I don't see that we had any choice but to do the bailout. In my opinion, Barney Franks had it right: Once Paulson had announced that a depression would ensue without the bailout, his pronouncement became a self-fulfilling prophecy.

Basically, I agree with his analysis that our economy has been kidnapped and is being held for ransom. Unlike him, I think we have to pay off the kidnapper.

Flame away...